City of London may be forever changed by Brexit

20 июня 2016, 16:23

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No less than 12% of UK GDP comes from financial services, underscoring the City of London’s importance to the British economy. Despite competition from New York, London is still the leader among financial centres with an estimated global market share of 40% in currency trading and almost 50% in interest-rate derivatives. On top of that, almost 20% of the world’s hedge fund assets are placed in London.

Even after considering the economic slowdown, negative interest rates and fragile financial markets, shares of UK-based banks in the FTSE 100 Index are down 36% on average in the past year. Since the recent highs in mid-May, shares have gone down again as surveys on average point to strength for the Leave campaign. Why could a Brexit change everything for the City of London?

It’s all about passporting

Under current law, any UK authorised firm is free to do business within the European Economic Area (EEA) through a “passport” from UK regulators. This option makes it possible for non-EU banks such as JPMorgan Chase to access Europe from only one financial hub. Should the UK vote for leaving the EU, the price of the passporting right would increase dramatically, making it a very tough negotiation point for British prime minister David Cameron.

Brussels would likely not accept the Norwegian model whereby the UK would leave the EU but stay inside the EEA unconditionally. This would be political suicide as other member countries without the euro, such as Denmark and Sweden, could be tempted to hold referendums on EU membership as well. The Norwegian model also only makes sense for countries that never were inside the club.

The hard exit model means the UK would lose key influence over EU legislation and passporting would be off the table. A softer version would allow the UK to keep passporting but on certain conditions such as convergence of EU and UK laws governing financial markets.

A Brexit would in any case open up for more power to Paris and Frankfurt which have never succeeded in taking serious market share from London. Even the clearing houses handling euro-denominated trades are located in UK. In any case, Brexit poses a huge risk to financial firms and many are already implementingcontingency plans in case of a messy outcome. Many banks have warned of massive layoffs and HSBC has said that around 1,000 of its investment banking employees would have to move to Paris. The City of London may never be the same again after a Brexit.

A good indicator of the high risk discounted in financial markets is implied volatilities for FTSE 100 compared to banks. The implied volatility for FTSE 100 July-15 ATM options is around 25% compared to around 58% for Royal Bank of Scotland (RBS). Investors can collect 7.1%-points in premium before commission by selling ATM straddle on RBS and buying ATM straddle on FTSE 100. The option market also shows that the market is less worried about HSBC. However, puts are generally more expensive than calls on UK banks.

How should investors navigate the Brexit event?

It is clear that no other segment of the UK equity market is more vulnerable to a Brexit than UK domiciled banks. A lot of downside risk has already been priced into these banking stocks. As such a short trade is not very attractive from a risk-reward perspective. GBPUSD risk-reversals (at around minus 8) are already indicating the direction of the flow and thus how worried the market is over the recent momentum to the Leave campaign.

Barclays daily share price since June 2015, Source: Saxo Bank

This has influenced calls on a bank such as Barclays. The C165 July-15 is priced at 12p translating into around 7.2% premium. With around three weeks from the UK referendum to expiry of this call option a no Brexit would very quickly be incorporated fully into Barclays share price.

There is around 14% upside to recent highs at the end of May based on prices on June 13) While the premium may seem steep, it would easily be overcome should the UK decide to remain in the EU.

Many lights may be switched off permanently should Britain vote to quit EU. Pic: iStock